Tuesday, April 2, 2019

The Agony Behavioral Biases of Risk

Most of us have a natural instinct of understanding the basic foundation of risk.

For example, when we are crossing in the middle of the road, we look instinctively interested to both left and right to see if there's any incoming vehicles that might hit us. We know the risk is higher if we cross in the middle of the road than if we walk a few meters to wait for the traffic light but yet most of us still do it in order to save a few seconds of time.

Our brains are wired to take impulse command instantly that it can calculate and decide which risks is worth taking and which is not.



The same theory applies when investors are investing in the stock market.

Most people associate risk with a falling market because that's when they lose their money and see their networth go down. It's not a nice feeling to have when you see your hard earned money being swiped off in the market everyday.

This is the main reason why contrarian investing is so unpopular amongst many retail investors.

They would prefer to wait out and go into cash when the market is bad and then tends to go in when the economies looks better. But there are always news in the market that will spook investors such as the weekly market report, inflation and monthly jobs report will tend to "move" the markets once in a while.

They ended up either waiting for too long or going into safer investment first that are sometimes too safe for their own good.

Human instinct also typically tends to prevail over the larger safety in numbers, which is also known as herd investing.

As small individual investors in the bigger market, they tend to feel safer and more confident investing alongside someone who is equally bullish in a rising market, deliberating positive bias confirmation that what they are doing is right since everyone is doing the same thing.

This comfort can be costly especially if you are much behind the queue pack in the larger herd chain.

The surge in buying activity and the resulting bullish sentiment over time is self-reinforcing, propelling markets to move even higher that will eventually lead to over-valuation and self-destructing for individual investors.

The propensity for herd behaviour is further propelled by the disposition effect of loss aversion when the stock market turns for the worst.

This is a behaviour effect where investors tend to keep their losing investment for longer time-frame while selling their winners too soon. The idea behind this behaviour is that as long as there's profits to be made, it's never wrong to take them off the table. But if the investments are in the loss position, then there is a tendency to hold it until the market rebounds. To them, as long as they have not sold their investment, it is not considered a loss.

Many of these behavioral biases we have are ingrained in our ability to pick out the risk we face in our day to day life.

They are not something we can change them overnight because we are not trained to do that.

It has to take years of training, experience and refining to distill the behavioral biases we have and it is still not perfect.

But we should start making the desired changes now because the longer we wait the harder it becomes to change them.

Thanks for reading.

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3 comments:

  1. from the book of behavioral investing, doing something against the herd, the brain reacted similar to pain. So being a contrarian mean constantly receiving that pain.

    Human feels stronger emotion from losses than winning

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  2. Be very disciplined and consistently apply money management and positioning sizing as part of behavioral investing across market cycles. Position sizing will determine our investment performance over long run. Limit losers and let big winners continue to run and add on; but this can be really tough across market cycles.

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  3. Hi B, this is a great write-up!! "know yourself, know your enemy,..." one will need to understand our "behavioral " and biases as market is "90% psychology " ... we tend to see people / investors over-react and act irrationally during crisis or market boom ...
    Thanks for sharing ... Cheers !! :D

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